Parsing Bernanke’s Testimony in Search of Truth

The exercise in which the Chairman of the Federal Reserve goes to Capitol Hill to joust with Congress over monetary policy occurs twice a year. After each round, there is an opportunity to look at the results and consider what has been learned. For those who cannot get enough of monetary policy, the House Subcommittee on Monetary Policy and Trade, chaired by Rep. John Campbell, R-Calif., will hold another hearing next Tuesday on the Fed’s quantitative easing program. Whereas yesterday’s article concentrated on monetary policy, this article will examine important issues outside that realm.

A threshold question is whether the infallibility that the Fed Chairman enjoys with respect to monetary policies extends to the field of bank regulation. From time to time, legislatures in the United States and the United Kingdom have considered whether bank regulation should be a province of the central bank or whether it should be placed in the hands of agencies solely dedicated to this function.

During the consideration of the Dodd-Frank Act, this issue was considered again, based on the demonstrated failures of the Fed that contributed to the 2008 episode of the financial crisis. However, once again, the Fed not only maintained its regulatory authority, but on balance ended up with more, having surrendered consumer regulation to the newly created Consumer Financial Protection Bureau and gaining authority to supervise the holding companies of nonbank financial institutions that will be designated as “systemically important” by the new Financial Stability Oversight Council.

Three issues will illustrate the difficulties readers face whenever they try to figure out what the Fed is doing with its bank regulation powers and how failures on the part of the Fed might contribute to the next episode of the ongoing financial crisis:

1. Pushout rules. When the Gramm-Leach-Bliley Act of 1999 was enacted to formalize the repeal of the Glass-Steagall Act and enable Citigroup to proceed with its merger of its bank and insurance units as demanded by its CEO Sandy Weill, who now calls for the breakup of “too big to fail” banks, the concept of “functional regulation” was born.

Each function of the group would be regulated by the agency with the charter and expertise to deal with that business. Thus, the bank regulators would regulate banks, state insurance regulators would regulate insurance and securities regulators at the Securities and Exchange Commission (SEC) would try to regulate securities activities.

However, the banks always contended that securities activities should be allowed to be conducted within the bank and not under subsidiaries that would have to be separately capitalized. They fought the requirement for the securities activities to be “pushed out” to subsidiaries, and with the help of Congress and of friendly bank regulators bent on regaining this turf from the SEC, including the Fed, they finally prevailed after about a decade of struggle. Now, under section 716 of the Dodd-Frank Act, the so-called Lincoln amendment, swaps activities of banks are supposed to be pushed out to subsidiaries.

Banks are going to fight this requirement as well, and Fed Chairman Ben Bernanke’s response to a question from Rep. Jim Himes, D-Conn., a former hedge fund manager, indicates that the Fed will enlist in this cause as well. Bernanke told Himes that there is no evidence the rules would make banks safer, but they could increase the cost of using derivatives for end users.

He said nothing about the need to control the demonstrated propensity of “too big to fail” banks, such as JPMorgan Chase, to take risks in their derivatives operations, as in the “London whale” incident, that could threaten the financial system again.

2. Bank reserve rules. This is another extremely complex issue that has been the subject of controversy for many years and that features a turf battle between bank and securities regulators. Rep. Brad Sherman, D-Calif., raised the issue of the pressure banks experience when they lend at low rates but risk a 100 percent capital charge in the event the asset becomes seriously impaired. He asked Bernanke if there is a way banks could value loans “conservatively” but avoid a “penalty” valuation.

Bernanke’s response was not directly on point, but rather he chose to talk about the ability of banks to maintain loan loss reserves against “general” risk not tied to a specific loan. The SEC has gotten into this act by challenging the practice of some banks are allegedly using their reserve accounts to manipulate earnings.

Bernanke stated that the Fed has supported more reserving, but he suggested having a “further conversation” with Sherman. The point of all this is that this issue is one more example of the difficulty in determining what the true condition is of the largest, most dangerous, “too big to fail” banks.

3. Bank capital rules. The issue of loan loss reserves leads directly to the broader issue of the capital standing of banks. Bernanke touched on this at both hearings this week in response to questions about the vulnerability of banks to stresses that might arise, for example, from a write-down of sovereign loans in the European Union.

Bernanke responded to a question from Sen. Chuck Schumer, D-N.Y., on Tuesday regarding exposure to Italy by asserting that the bank continually evaluates the extent of the vulnerability of the banks, but he dismissed it as merely “hypothetical” before acknowledging that if there were a question as to the ability of Italy to remain in the euro, this could have effects on bond rates and bank stocks.

Some legislators appear to be probing for more reliable information on the true condition of banks they believe are supported by a significant subsidy by virtue of their ability to borrow more cheaply than other financial entities because of the perception that they are backed by the federal government, much as Fannie Mae and Freddie Mac enjoyed implicit support before they collapsed into conservatorship.

The authorities denied that the debt of the housing government-sponsored enterprises (GSEs) had government backing, in the same way that they deny it with respect to the “too big to fail” banks, but in the end, the GSEs received explicit support.

I suspect that now this support is being provided by means of the so-called “Bernanke put,” which is the extension of support to any asset of the “too big to fail” banks in order to avoid recognition of embedded losses that might amount to as much as $15 trillion, equivalent to the entire gross domestic product of the United States.

The question no one asked this week is how, in light of the fragile state of the “too big to fail” banks, these banks can be allowed to pay dividends and buy back stock, as bank CEOs are telling analysts they will be allowed to do this year.

The exercise in which the Chairman of the Federal Reserve goes to Capitol Hill to joust with Congress over monetary policy occurs twice a year. After each round, there is an opportunity to look at the results and consider what has been learned.